Investigation: The business of high-frequency trading

This article was taken from the April issue of Wired magazine. Be the first to read Wired's articles in print before they're posted online, and get your hands on loads of additional content by subscribing online

In 2002, after 12 years at Bear Stearns, investment banker Adam Afshar came to the conclusion that, for all their supposed expertise, most Wall Street traders really weren't very good at predicting anything.

"I got the sense from my time there," says Afshar, "that market analysts have little insight and generally provide very little value to their firms." So Afshar set out to find market opportunities in, as he puts it, "a more systematic way". The result was Hyde Park Global Investments, a small trading firm based in Atlanta, Georgia, that doesn't hire market analysts or portfolio managers.

Instead, its employees are almost all physicists, computer scientists and mathematicians skilled in writing code and developing sophisticated algorithms inspired by evolutionary biology. The goal: to analyse historical financial data and spot and exploit fleeting opportunities in the market. "With algorithms and fast computing, even small firms can now buy and sell as fast as the biggest ones," Afshar says. "Technology lets you compete with firms having billions of dollars."

When Afshar says fast, he means very fast. What have become known as high-frequency trading (HFT) systems can execute transactions in milliseconds without human intervention -- basing their decisions on information they have received electronically. Joined by high-speed data links to the trading exchange, they draw on huge databases of historical data to test algorithms offline and then quickly use that knowledge to spot market opportunities and likely profitable trades.

They can execute those trades before anyone else has had a look in. In fact, to exploit split-second advantages, trading firms physically locate their servers as close as they can to the exchanges -- in some cases just a few metres away from the boxes where the trades are completed. The reason for all of this, says Joe Gawronski of New York brokerage Rosenblatt Securities, is that HFT requires extremely short "latency" to work -- a very small delay between sending an order and having it accepted, executed and receiving a confirmation, or, if it doesn't trade, confirmation of its being cancelled.

InfoReach, a New York-based company specialising in trading technology, has platforms capable of handling more than 10,000 orders per second with a sub-millisecond latency. Hyde Park Global relies on a trading platform that can execute up to 300 trades per second. It is currently relocating its servers so they run close to exchanges in New York, a practice known as "colocating".

"By colocating in New York," Afshar says, "we're able to take 21 milliseconds off our trades. In the past, 21 milliseconds was a trivial matter. Now it's pivotal." The computerisation of financial markets isn't a new phenomenon. In the 70s the New York Stock Exchange introduced the Designated Order Turnaround system, which routed orders electronically.

Throughout the late 80s and 90s the traditional open-outcry system was abandoned in favour of electronic trading desks across the world -- most famously in London in 1986, when the deregulation of the financial markets prompted a huge shift to screen-based trading. Since then increased market liquidity and technological advances have created ideal conditions for the spread of high-frequency trading. It now accounts for about 70 per cent of US equity transactions and significant fractions of trading volumes in many other markets.

In 2009, estimates of the total profits of the several hundred companies involved in such automated trading (out of roughly 20,000 firms currently trading in US markets) ran as high as $20 billion. But as greater numbers of companies invest in the systems, industry watchdogs and regulators are beginning to ask questions about the possibly damaging effects that high-frequency trading might have on markets and the wider economy.

Most alarming is the parallel that's being drawn between the unregulated trade in derivatives -- which some economists thought would make markets more stable and efficient -- that triggered the collapse of 2008.

Could high-frequency trading trigger the next great financial catastrophe? HFT firms argue that their strategy is centuries old and beneficial to markets. This is particularly the case with high frequency "market-makers", such as Getco and Tradebot, which provide a buying-and selling service to others. Market-makers provide liquidity by ensuring that other participants can always find a buyer or seller for any product.

They make only a small profit on each trade, but execute hundreds of millions of trades every year. "High-frequency market-makers step up and make shares available for purchase or sale at specific prices on a scale never before seen in securities markets," says Justin Schack, a vice president at Rosenblatt Securities. "This flood of orders helps to make markets as fair and efficient as possible." But market-making is only one of a number of popular HFT practices.

Comments

flash orders were invented to save route-out fees and they're are clearly intended to be used with computers - pretty far away from front-running.

Best 2 articles about HFT:http://www.zerohedge.com/article/dark-pools-price-discovery-and-level-playing-fieldhttp://seekingalpha.com/article/151430-high-frequency-trading-we-fear-what-we-do-not-understand

Hans Franz

May 1st 2010

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